The environment: The carbon bubble

The Carbon Tracker Initiative’s recent Unburnable Carbon 2013 report estimates that the consumption of the earth’s proven fossil fuel reserves would yield over five times the level of carbon emissions recommended by climate scientists to stay below a 2°C rise in temperature, the limit necessary to avoid dangerous interference with the climate system. Yet many listed fossil fuel companies are currently valued assuming that all resources will be extracted and consumed. If the assets underpinning the value of fossil fuel companies cannot be extracted without catastrophic climate interference, then the current valuations of these companies are fundamentally fl awed and the assets are ‘stranded’.

If governments act to keep the temperature rise below 2°C by putting a higher price on carbon – which arguably becomes more likely as this threshold is approached – then the value of these stranded assets, and the companies and sectors that hold them, will decline sharply. While certain groups have highlighted this risk [1], to date it has not been widely recognised by investors and not yet factored into models for which actuarial advice on funding and investment decisions are based.

“In the context of a declining carbon budget, these valuation models provide an inadequate guide for investors and need to be recalibrated”

Limiting carbon emissions

The 2002 United Nations Framework Convention on Climate Change incorporated the concept of avoiding dangerous climate change by limiting the rise in the global average temperature to no more than 2°C above pre-industrial levels by 2050.

Governments are currently preparing for a new international treaty in 2015 which will likely include further targets for reducing global emissions. The UK government has committed to a mandatory 80% cut in carbon emissions by 2050 on 1990 levels, with an intermediate target of 34% by 2020 [2].

The 2°C limit implies that there is a maximum amount of carbon dioxide (CO2) that can be emitted globally during the period to 2050, i.e. a carbon budget. Analysis by the Carbon Tracker Initiative and the International Energy Agency indicates that the carbon budget for a 2°C scenario is equivalent to CO2 emissions of between 565 to 886 billion tonnes (565-886 Gt) by 2050 [3]. The Carbon Tracker Initiative has stress tested these carbon budgets for different temperature targets against a 50% and 80% probability of peak warming [4] (see graph on page 24). It highlights the reduced room for manoeuvre of exploiting reserves.

The carbon budget

We are rapidly consuming our remaining carbon budget. According to the 2013

International Energy Agency report Redrawing the Energy Climate Map, CO2 levels in the atmosphere reached 400ppm in May 2013, having jumped by 2.7ppm in 2012 – the second highest rise since record-keeping began.

Bankable, not burnable assets

In the 2°C scenario, with a 50-80% probability of limiting temperature increases, the carbon budget represents at most one-third of the carbon embedded in the earth’s fossil fuel reserves. A dilemma therefore arises: do we adhere to the carbon budget constraint and fossil fuel reserves remain unexploited (i.e. assets will be stranded), or ignore the constraint, exploit all and roll the dice on a safe future?

While listed fossil fuel companies do not account for the total fossil fuel reserves, based on a pro-rata allocation of the global carbon budget, potentially 60-80% of coal, oil and gas reserves of listed firms’ reserves, which are priced into balance sheets and consequently share prices, are potentially unburnable and therefore of no value.

What should investors do?

Such a systemic risk threatens the stability of financial markets. Markets appear unable or unwilling to factor in the long-term shift to alow-carbon economy into valuations and capital allocation. This means:

● Investors need ongoing education to understand their exposure to a range of future scenarios.

● Investors need to ensure that these risks are considered in the risk management and asset allocation processes.

● Investors should ensure those charged with the management of equity portfolios are actively engaging with companies to ensure that management are scrutinised and challenged effectively on their use of capital.

Strategic Asset Allocation found that climate risk could represent 10% of portfolio risk and the emergence of a carbon bubble cannot be ignored.

There needs to be a change in the mindset of actuaries to redefine our understanding of risk. This issue should be brought to the forefront of discussions with clients so we, and they, can begin to consider the possible long-term implications of climate risk on both assets and liabilities.

Failure to do so could result in misaligned investment strategies and the significant devaluation of assets. Failure to do so could make it too late to act.